Description

R.R. Donnelly (“RRD”) is another great option stock with underappreciated fundamentals, completely sandbagged guidance and incredible asymmetry.  The first leg to this trade is the re-rate of this stock from 3.5x 21 EBITDA ($400mm) to 4.0x which would mean upside to $7/share from $3ish today.  As the market realizes that the company is more likely to deliver $500mm of EBITDA and $290mm of LFCF … I suspect that the stock could move to $20 (5.0x EBITDA with a 20% LFCF yield.)

What does RRD do?  Frankly, this is not an incredible business.  There are many pieces to this company that are weak aare only worth 3-3.5x. However, several are worth far more and those are large parts of EBITDA.  It will take 20 pages to explain all of the puts/takes.  I would point you to the following.  There was an article that stated that RRD was debating the sell of its Asia/China asset for $800mm from this in late 2020. 

*R.R. DONNELLEY IS SAID TO SEEK $800M IN ASIAN ASSET DISPOSAL (12/16/20)

Subsequently, the Chinese segment has blown the doors off the walls and is likely worth more.  Based on segment data, this sale price would likely imply AT least a 6x multiple and probably more like an 8x+.  China has a large packaging business which is in secular growth.   Of note, the middle class is growing so fast that its commercial print segment continues to grow.  If $800mm reflects a 6.0x multiple (which would surprise me on the low-end), the PF valuation/balance sheet would be the following.  Net leverage would drop from 2.8x to 1.4x and TEV/EBITDA would go from 3.3x to 2.2x. 

In addition to China, the company has several domestic assets that are in growth modes and worth far more than 3.0x.  Packaging, Labels, Supply Chain, Business process outsourcing and the entire Marketing Solutions business.  To be clear, these segments are not experiencing exponential growth.  However, they are stable and generally upward sloping segments.  Given their EBITDA/FCF characteristics, these segments are likely worth 6x+.  These assets and my pro-rata estimate of China exceed 50% and possibly 60% of sales.

The 800 LB gorilla which will DISTRACT you and the market… the commercial print segment is in secular decline.  Commercial Print is 15-20% of sales; including Asia.  The segment has secular decline problems.  However, RRD doesn’t print yellow pages anymore.  RRD is far more efficient than many of the Mom and Pop peers.  Given its scale, it can flex down efficiently to drive capacity utilization and generate cash.  Once demand hits rock bottom (which will happen), it will carve out an attractive niche.  If you ran a DCF on the above, I suspect its worth its worth far more than 3.0x.

In addition, the company has exited segments that were in decline (Logistics).  As a result of all of the above and portfolio adjustments, the mgmt. team appears to have positioned the portfolio to deliver extremely LSD sales growth ex the pandemic.  This is evidenced by the fact that they would have delivered on sales in growth in 1q20 ex the implosion China due to Covid.  Further, their guide for 2021 is for revenue growth despite the meaningful loss of census revenue which was a 1x lift in 2020. 

You will be pestered by people talking about yellow pages… comments about “horrible business.”  They haven’t opened a page of any document to investigate what lies beneath surface.  Again, I am not saying this is Amazon… just a below average business with an above average management team who has held EBITDA over $400mm for several years while experiencing declines in segments and dumping non-core assets which generated EBITDA. 

The equity market is paying zero attention.  1 or so sellside analysts cover it on the equity side.  HOWEVER, there is one large pool of capital that is more actively watching this… the high yield market.  They are paying attention.  The bonds on this stock have been well over par for a long time.  THIS IS A VERY INTERESTING FACT.  A large and more liquid part of the capital structure and a group that is paying far more attention believes that this company is worth 2.8x net leverage.  The stock on the other hand attributes the smallest of premiums to net debt as they value the whole thing at 3.5x.  By comparison, BTU bond holders believe that the company is worth 700-800mm whereas the equity market believes $1.5bn.

RRD has been guiding very successfully in that they have beating guidance handily through the pandemic and before.  2021 guidance appears cautious which is defendable given the pandemic creates uncertainty so early in the year.  However, some of this goes to far.    As an example interest expense guidance is >$120mm.  They paid down $500mm of debt during 4Q and will spew cash in 2021.  Simple math points you to $105mm of PF interest expense.  Several segments were severely impacted by the pandemic and are poised to bounce far harder than LSD.  Lastly, Adjusted Net Income has to be much higher.  They removed an extremely large amount of costs during 2020.  If you use 2H20 Gross Margins and SG&A as a % of sales on 5% more sales… this gets you to $475-500mm of EBITDA vs their guide of $405mm.  This assumption IGNORES the fact that sales growth will have materially positive impact to margins as incremental margins are higher.  In addition, they will benefit from costs saves implemented in 2H20 which will be fully realized in 21.  lastly, this management team will will reduce costs further in 21.

valuation and asymmetry… as described above, the market cap is a tiny stub on top of a large amount of debt.  I associate 3.5x EBITDA and 75%+ LFCF yields with companies with sharply declining business … like off a cliff.  As I mentioned before, the management team has held $400mm of EBITDA while selling material amounts of assets and fighting a decline in segments.  Even if we assume that 2021 guidance is correct, the valuation does NOT reflect the innate stability of this situation.  The stock should be at least 4.0x $400mm which is $7/share or >100% upside.  Should a more reasonable scenario play out where EBITDA is closer to $500mm… I think the market will start to get the joke.  If 2022 seems to be another stable year… is 6.0x 500mm off the table?  That would be $30/share.  I won’t be there if it happens but this stock has some real get up and go.  Conversely, I see little to no downside given the sandbagged nature of guidance and the conservative valuation placed on it.   One aside, the company will receive its last $50mm payment for a commercial property it is selling in China.  I was initially fearful that the sale could break.  However, this asset is in a highly attractive location and has likely appreciated in value since the sale was announced.  The buyer will lose $130mm if the deal breaks.  It would be insane for them to not make the final payment and then flip the building at a premium to their purchase price.  As a result, I am including this $50mm payment in my TEV.  I initially bought this stock in the $1/share region.  However, I added substantially yesterday at $3.1/share.  Hope this helps.

Catalyst

Quarterly earnings, further asset sales